Neil Unmack’s Profile

Running with the ABS bulls can be dangerous

European asset-backed bond prices have gained strongly in recent weeks, but the rally could end in tears.
Prices have rallied as bond investors have increased their allocations to asset-backed debt and some have set up specialist funds to take advantage of distressed prices. They have also been helped by the general increase in demand for all kinds of credit. Accordingly, the spread on top-rated mortgage-backed bonds sold by benchmark UK issuer Lloyds TSB has narrowed to 1.9 percentage points over the 0.886 percent Euribor rate, down from about 3.2 percentage points over the last six weeks, according to broker Brains Inc.
And in many cases, good returns are still on offer.
But there are signs that investors are becoming indiscriminate in their search for yield. One warning sign are optional call dates. In the good years many bonds were structured with optional calls that enable an issuer to repay debt before all the mortgage loans have paid down. In pre-crisis times it would have been easy for a bank to call the debt and refinance the remaining mortgage loans. That’s not the case anymore — any bank that choosing to redeem bonds would be giving investors a windfall, arguably to the detriment of its own shareholders.
Many Dutch mortgage-backed securities are now trading at levels that imply investors believe issuers will redeem them at their planned call dates, although some Dutch issuers have already chosen not to do that and more will likely follow. After all, it is logical from their perspective. It’s far cheaper for them to leave the bonds outstanding rather than have to finance them at today’s rates.
Perhaps buyers know something about the originator’s financial prospects or intention that the rest of the market doesn’t, but this looks like exuberance. And it could be painful if punctured. A bank choosing not to redeem bonds at their call date will cause debt maturities to extend and prices to fall.
There are further signs of bubbliness. Some of the riskier mortgage-bonds from bombed out housing markets, such as Ireland and Spain, have rallied sharply too, according to traders. Yet there is little reason to expect good news in those markets for the foreseeable future. The yield on some Santander mortgage-backed debt has compressed inexplicably by some 2.6 percent over the last six weeks.
The market may be getting ahead of itself partly for structural reasons. Many mortgage backed securities — especially those backed by commercial real estate — are too complex and unpredictable for most investors to touch, so instead they will chase up the simpler-looking residential mortgage or consumer loan-backed debt.
There are also broader issues of supply and demand. An accounting wheeze introduced last year allows European banks to shift securities from their trading desks their loan books. This allows them to avoid the earnings volatility involved in marking these assets to market (or to avoid revealing their true losses, depending on your view). But the effect of this has been to take a large chunk of traded securities out of the market, making price movements more volatile and, arguably, prone to overshoot.
Investors and banks may be united in wishing to see prices move higher. Prices rises help trading desks book profits from legacy positions, as well as banks stuck with unsold bonds. But investors should be wary of reading too much into price movements. They should also remember that it’s hard to cash out of illiquid markets when they turn down.
And conditions could swiftly turn. Rising unemployment levels across Europe as companies rein in costs will likely push up defaults and losses, hurting deals’ credit quality.
Investors who delved into riskier credits in the search for yield may rue the day.